KESTREL CAPITAL March 2014 · March 2014 SAFARICOM LTD ... We expect increased competition on...

KESTREL CAPITAL Member of the Nairobi Securities Exchange

March 2014

SAFARICOM LTD

Recommendation: ACCUMULATE We maintain our ACCUMULATE recommendation on Safaricom with a 1 year target price of KES 12.56 repre-

senting upside of 6.9% which is primarily limited by its current market valuation. The potential upside along with

the dividend yield of 3.9% should provide total return of 10.8%. We forecast that EPS will grow 43.1% y/y to KES

0.63 in FY14 driven by faster growth in non-voice revenues (+31.2% y/y), relative to voice revenue (+12.2% y/y)

and improvements in margins (contribution margin: +157bps y/y to 64.4%, EBITDA margins: +241bps y/y to

42.0%). Beyond FY14, we expect data and M-PESA to be the drivers of revenue growth as costs decelerate as a

result of improving cost efficiency. Stable capital expenditure and negative net debt will mean that the additional

cash generated from the improving performance will result in higher dividends (3-year forward CAGR of 47.8%)

only limited by potential acquisitions of more fibre capacity or ancillary businesses (Safariom and Airtel have bid

for Essar Yu). At current prices, the company has a trailing P/E of 26.7x and EV/EBITDA of 9.6x compared to the

regional comparables average P/E of 12.2x and average EV/EBITDA of 6.9x. The company’s growth prospects

(+44.9% y/y growth in EPS in 1H14), however, justify the premium.

Positives

Voice revenue growth will be driven by increased subscribers (+8.3% y/y in 1H14), lower churn (18.4% in

1H14 from 28.5% in 1H13), improvement in call quality and the organic growth of minutes of use

Non-voice revenue will account for a larger portion of revenue (from 36.7% of total revenue in 1H13 to

39.4% in 1H14) on account of higher growth rates (non-voice revenue grew 30.2% y/y compared to voice

revenues that grew 12.0% y/y in 1H14)

The rise in M-PESA revenues (+19.8% y/y in 1H14) will be driven by increased active subscribers (+19.2% y/y

in 1H14) in the short term and increased M-PESA usage in the longer term

Promotions, bundles and growing subscribers will drive growth in SMS revenues (+48.7% y/y in 1H14)

Increases in active mobile data customers (+51.7% y/y in 1H14) and usage will drive the growth in mobile

data revenues (3 year forward CAGR of 23.1%)

The new fibre optic network will support the growth in fixed data subscribers

EBITDA margin expansion (EBITDA margin is 41.7%) will be driven by growth data revenues (mobile data and

fixed data EBITDA margins are 55.0% and 43.0% respectively)

The company will earn net finance income due to more cash than borrowings

Free cash flows to rise (3 year forward CAGR of 49.5%) on growing EBITDA and stable capital expenditure( at

approximately KES 27.0bn per annum)

We expect higher dividends (3 year forward CAGR of 47.8%) as free cash flows continue to grow

Negatives

Handsets sales decline ahead of the introduction of 16.0% VAT

Accelerated depreciation will drag down earnings growth

We expect increased competition on M-PESA and fixed data from new players

Safaricom might be a target for increased regulation due to its dominant market position

FY10 FY11 FY12 FY13 FY14F FY15F FY16F

Revenue 83.96 94.84 107.00 124.29 146.12 166.45 189.48

y/y % ch 13.0 12.8 16.2 17.6 13.9 13.8

EBITDA 36.61 35.73 37.50 49.18 61.00 69.99 81.04

y/y % ch (2.4) 5.0 31.1 24.0 14.7 15.8

EPS 0.38 0.33 0.32 0.44 0.63 0.77 1.03

y/y % ch (13.2) (4.0) 38.9 43.1 22.4 34.3

DPS 0.20 0.20 0.22 0.31 0.38 0.58 0.76

y/y % ch - 10.0 40.9 22.7 52.6 31.0

EV/EBITDA 12.9 13.4 12.8 9.6 7.6 6.4 5.3

P/E 30.9 35.6 37.1 26.7 18.7 15.2 11.4

Div yield 1.7 1.7 1.9 2.6 3.2 5.0 6.5

(Source: Company, Kestrel Capital Research)

Bloomberg Ticker : SAFCOM KN

Reuters Ticker: SCOM NR

Share Statistics Price (KES) 11.70

Issued shares (m) 40,044.6

Market cap (USD m) 5,422.7

Year end March

Free Float % 24.9

Foreign ownership (%) 13.1

Av daily trading vol (USD) 1,573,937

Price Return Absolute Excess 3m 13.0% 11.2%

6m 49.0% 33.8%

12m 96.6% 66.7%

Price Trend

Source: NSE

Analyst Kuria Kamau [email protected] +254 20 2251 758 +254 20 2217 049 www.kestrelcapital.com

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NSE All Share Safaricom

Safaricom Update March 2014 KESTREL CAPITAL

Positives

Voice revenue growth will be driven by increased subscribers (+8.3% y/y in 1H14) and lower

churn (18.4% in 1H14 from 28.5% in 1H13): In 1H14, Safaricom managed to grow its subscrib-

ers by 8.3% y/y to 20.8 million. This was much faster than the industry as a whole which record-

ed 2.9% y/y growth in subscribers. It effectively means that Safaricom was able to acquire addi-

tional subscribers from its competitors and its subscriber market share rose to 66.5% in Sep-

tember 2013 from 63.2% a year earlier. The improvement in market share has also been driven

by declining churn rate. The subscriber churn rate declined to 18.4% in 1H14 from 28.5% in

1H13. Looking to 2H14, we expect faster y/y growth in subscribers. On 30 September 2012,

following a directive from the CCK, Safaricom switched off 680,000 subscribers with counterfeit

phones. Approximately 3 months later, on 4 January 2013, Safaricom suspended communica-

tion services for 2.5m subscribers following the government promulgation of new regulations

that required the mandatory registration of mobile subscribers. While both events had the

effect of reducing subscriber numbers, Safaricom still managed to grow subscriber numbers by

1.0% y/y in 2H13. Now (in 2H14), a year later, most of the disconnected subscribers are back

onto the network. These additional subscribers will drive revenue growth in 2H14 as it did in

1H14. Also, as at the end of February 2014, it emerged that Safaricom and Airtel were in the

process of buying out Essar Yu. Airtel was to take up Essar Yu’s subscribers while Safaricom

would acquire Yu’s infrastructure and technical staff. There could be a possible windfall of addi-

tional subscribers should some of Yu’s subscribers decide to move to Safaricom instead of re-

maining at Airtel or should Orange decide to pull out of the Kenyan market. Beyond 2H14, Sa-

faricom’s superior products particularly M-PESA will continue to help retain subscribers and add

new subscribers. In the longer term, we expect subscriber numbers to grow in line with Kenya’s

population (+2.6% y/y). Should a new competitor come into the market following the exit of

Essar Yu, we don’t expect significant change in the status quo.

Improvement in call quality and the organic growth of minutes of use will result in growth in

total minutes (3 year forward CAGR of 17.4%): The Communications Commission of Kenya

(the regulator) issues equal spectrum to mobile network providers regardless of the number of

subscribers. While this method ensures a fair playing ground for all providers, it has the disad-

vantage of causing congestion in networks with more subscribers thus lower call quality. Sa-

faricom has 66.5% of all mobile subscriptions on its network despite having the same amount of

spectrum as its competitors. While the impending renewal of Safaricom’s license offers the op-

portunity to move to a new competitive bidding system, it is likely to be postponed until in the

next round of license renewal in 2024. It’s not immediately clear if Safaricom will acquire Essar

Yu’s spectrum as part of the acquisition deal. In a bid to improve call quality, Safaricom

launched its “Best Network in Kenya” programme in FY13. As of the end of the FY13, it had al-

ready realized some benefit of the programme with dropped calls down 25.0% y/y and network

downtime declining 66.0%. As at 1H14, it had made more progress in improving call quality. It

had modernized 2,650 of its radio sites (85.0% of its network). It also increased the capacity on

1,200 sites which will increase voice services by 20.0% and upgraded 65.0% of the transmission

(Source: Communications Commission of Kenya)

(Source: Safaricom)



network to Internet Protocol. In 1H14, total minutes grew 12.6% y/y on account of more sub-

scribers and increased minutes of use (average monthly call minutes per subscriber) for existing

subscribers. For FY14E, we forecast that total minutes will grow 14.4% y/y largely due to 13.6%

more subscribers in FY14 than FY13.

Higher Total Minutes (3 year forward CAGR of 17.4%) will more than compensate for the de-

cline in effective minutes yield following the final cut in mobile termination rates (-13.9% y/y

on 1 July 2014): The Kenya telecommunications’ regulator, the Communications Commission

of Kenya (CCK) announced a glide path for mobile termination rates (MTRs) in 2012. MTRs were

to decline 34.8% y/y on 1 July 2012, 20.1% y/y on 1 July 2013 and 13.9% y/y on 1 July 2014. The

first two were implemented and the final cut is due to happen on 1 July 2014. Safaricom is a net

off-net call receiver by virtue of having more subscribers than all other networks (66.5% sub-

scriber market share). Lower MTRs mean a more rapid decline in interconnection revenue than

in interconnection costs for net off-net call receivers. Notably, the two last cuts did not have a

significant effect on Safaricom’s revenues and contribution margins as growth in total minutes

more than made up for the decline in minutes yield. As a result, we also do not expect a change

in Safaricom’s call tariffs (flat rate of KES 4.00) in the foreseeable future as increased volumes

will make up for lower relative pricing.

Increased minutes of use will be the driver of growth in Voice ARPUs in the longer term: As at

September 2013, Kenya’s mobile phone penetration stood at 76.9% which was below South

Africa’s penetration rate of 117.6%. The real mobile phone penetration rate is much lower if

subscribers with dual SIMs are removed. Despite having 63.2% in subscriber market share and

76.7% in minutes share as at the end of 1H13, Safaricom was able to grow its subscribers by

8.3% y/y and total minutes by 10.1% y/y to 66.5% subscriber market share and 79.1% minutes

market share as at the end of 1H14. Going forward, however, we believe that increased

minutes of use will drive ARPUs (Average Revenue per User). With increasing real incomes, sub-

scribers will be able to talk longer. Currently, Safaricom’s MOUs is 94 minutes; significantly be-

low Vodacom South Africa’s 124 minutes of use. Therefore, there’s an opportunity to grow

minutes of use in the longer term.

The change in the methodology of voice quality tests should reduce the risk of penalties and

non-renewal of Safaricom’s license: The regulator (the Communications Commission of Ken-

ya) announced that it was looking outsource its voice quality tests to an independent consult-

ant. Furthermore, the regulator stated that failure to meet the set standards would result in a

penalty amounting to 1.0% of revenue. The tests which were previously carried out by the regu-

lator’s staff were constantly disputed by the telecommunications companies. Safaricom is confi-

dent that it will meet the minimum standards reducing the risk of having to pay the penalty. We

also expect that the company’s license will be renewed before the previous one expires on 30

June 2014.

(Source: Safaricom)

(Source: Safaricom)


Non-voice revenue will account for a larger portion of revenue (from 36.7% of total revenue

in 1H13 to 39.4% in 1H14) on account of higher growth rates (non-voice revenue grew 30.2%

y/y compared to voice revenues that grew 12.0% y/y in 1H14): Due to the slower growth in

voice revenues (+12.0% y/y) relative to non-voice revenues (+30.2% y/y), voice now accounts

for 60.6% of total revenue from 63.3% in 1H13. SMS revenues grew 48.7% y/y in 1H14 and now

accounts for 9.2% of total revenue, up from 7.6% in 1H13. Mobile data, following 43.1% y/y

growth in 1H14, now accounts for 6.1% of revenue, up from 5.0%. The M-PESA’s contribution to

revenue increased to 18.1% in 1H14 from 17.6% in 1H13. Fixed data as a portion of revenue,

despite strong growth of 20.8% y/y in 1H14, increased marginally to 1.8% in 1H14 from 1.7% in

1H13.

The rise in M-PESA revenues (+19.8% y/y in 1H14) will be driven by increased active subscrib-

ers (+19.2% y/y in 1H14) in the short term: In 1H14, M-PESA revenues grew 19.6% y/y largely

due to a 19.2% y/y increase in active subscribers. Active M-PESA subscribers represent only

55.5% of the total Safaricom subscribers. The company has the opportunity to almost double its

active M-PESA subscribers by encouraging more subscribers within its network to use M-PESA.

M-PESA is by far the most popular money transfer service and therefore, there is little room to

grow by acquiring market share. In the longer term, we expect M-PESA subscriber growth to

slow and match voice subscriber growth (in line with population growth).

Increased M-PESA usage will contribute to higher M-PESA revenues in the longer term (3 year

forward CAGR of 17.0%): As at 1H12, the benefits of the newly launched products were yet to

be felt as average usage per customer only grew 2.0% y/y. The company launched a new mer-

chant service, LIPA NA M-PESA which enables M-PESA subscribers to make purchases for goods

and services from retailers using M-PESA via direct payments. Initially, Safaricom was to earn

1.5% of the value of the transaction but it later reduced it to 1.0% of the value of the transac-

tion in order to encourage increased usage. We expect Safaricom to run promotions to increase

usage on the product. There are several opportunities to encourage increased usage of M-PESA.

One example is the fact that Safaricom is well placed to take advantage of the move to cashless

transport payments as of 1 July 2014. Also, following the success of use of M-PESA in EA Brew-

eries’ distribution network of, Safaricom is looking to sign on other consumer goods companies

including BAT Kenya, Unilever Kenya etc. Moreover, should the Central Bank of Kenya approve

the increase in M-PESA limits from a maximum of KES 140,000 (USD 1,600) a day and KES

70,000 (USD 800) per transaction, there will be an increase in transaction values and therefore,

more fees to Safaricom based on its staggered fee system. Ideally, Safaricom would like compa-

nies to pay salaries with M-PESA, employees to purchase goods and services using LIPA NA M-

PESA and save the balance on M-Shwari. Banks have created new products that are linked to

the M-PESA system like KCB Bank’s M-Benki product that allows M-PESA subscribers set up a

bank account using the M-PESA system. These will help increase the volume and value of trans-

actions. As at 1H14, Safaricom added 33,316 agents since the end of 1H13. With more M-PESA

agents available, there will be increased accessibility and therefore, increased M-PESA usage.

(Source: Central Bank of Kenya)

(Source: Central Bank of Kenya)


We forecast that increased usage and growth in active M-PESA subscribers will result in a 3 year

forward CAGR of 17.0% in M-PESA revenues.

Promotions, bundles and growing subscribers will drive growth in SMS revenues (+48.7% y/y

in 1H14): Last year, Safaricom ran the Bonyeza Ushinde promotion which contributed signifi-

cantly to the 30.0% y/y growth in SMS revenues in FY13. The effects of the promotion were

sticky as the higher SMS volumes recorded during the promotion continued to the next quarter.

In 1H14, Safaricom ran the second round of the promotion at a higher price per SMS and as a

result, Safaricom’s share of the total industry SMS increased to 95.6% as at the end of 1H14

from 80.3% y/y in 1H13. The effect of higher SMS volumes and pricing resulted in 45.9% y/y

(8.0% h/h) increase in SMS ARPU. Additionally, a 7.9% y/y increase in active subscribers helped

raise SMS revenues to KES 6.4bn, 48.7% y/y higher than 1H13. Smart pricing on SMS bundle

products following the removal of the unlimited SMS bundle also contributed to organic growth

in SMS volumes. We believe that Safaricom will continue to run the Bonyeza Ushinde promo-

tion annually to sustain the growth in SMS revenues. Increased SMS subscribers and more take-

up of the SMS bundles will be the long term drivers of SMS revenue growth.

Increases in active mobile data customers (+51.7% y/y in 1H14) and usage will drive the

growth in mobile data revenues (3 year forward CAGR of 23.1%): As at end of 1H14, Sa-

faricom was the largest mobile data provider with 73.2% of all mobile data subscriptions. Dur-

ing the period, it was able to grow its mobile data revenue by 43.1% y/y on the back of a 51.7%

y/y rise in mobile data subscriptions. Safaricom cut the average price per MB by 21.0% to keep

its pricing in line with its competitors. The 21.0% cut in the average price per MB had a net neg-

ative impact on existing users as mobile data usage increased by 18.0%. However, we expect

usage to continue growing going forward. We forecast a 3 year forward CAGR of 23.1% for mo-

bile data revenues based on increased subscribers and usage. To support increased usage, Sa-

faricom has invested in additional capacity. The company acquired Essar Yu’s stake in the un-

dersea fibre optic cable, The East Africa Marine system (TEAMs), thereby increasing its stake to

32.5%. The company has extended the population coverage of 2G to 89.0% and 3G to 56.0%. It

also upgraded 95.0% of 3G sites to a minimum of 21Mbps. During the 1H14 results announce-

ment, the company announced that it would build the largest 4G network in the region and

provide primary schools with free internet should the government allocate it with more spec-

trum following the move away from analog broadcasting to digital broadcasting.

The new fibre optic network will support the growth in fixed data subscribers: Fixed data rev-

enue grew 20.8% y/y in 1H14 on account of a 15.4% y/y increase in ARPU. The wide variety of

products on the fixed data are driving increased usage. Smart pricing in the competitive fixed

data segment contributed to improved ARPU. Growth in subscriber numbers on fixed data,

however, continues to lag other business lines. Safaricom’s market share in fixed data is 7.8%

and it is currently the 5th largest fixed data provider in Kenya behind Wananchi Telecom, Liquid

Telecom, Access Kenya and Telekom Kenya. In 1H13, Safaricom announced that it intended to

build its own fibre optic network of approximately 2,400km. As at the end of 1H14, it had laid




the first 570km of fibre in major parts of Nairobi. This compares to 1,000km owned by Liquid

Telecom and 400km owned by Access Kenya. The company late last year advertised that it

would connect buildings within the Central Business District to the company’s fibre line for free.

Once a building is connected to its grid, Safaricom would then offer its services to the building’s

tenants.

M-Shwari will be a sticky product but we don’t expect a significant contribution to revenues

in the medium term: Safaricom launched M-Shwari in conjunction with Commercial Bank of

Africa in November 2012. M-Shwari is a banking product that allows M-PESA subscribers to

open a bank account with Commercial Bank of Africa without having to visit any of its branches.

Depositers earn interest and subscribers can borrow money for a period of 30 days at a flat rate

of 7.5%. As at November 2013, a year after its launch, customer deposits from M-Shwari had

grown to KES 24.0bn from 6.0m depositors. Commercial Bank of Africa had lent out KES 7.8bn

to M-Shwari subscribers but had recorded defaults worth KES 241.0m. Notably, Safaricom does

not incur any credit risk. It takes 30.0% of the interest charged on the loans and benefits from

increased M-PESA transaction volumes and values.

Contribution margins will continue to improve (+293bps to 64.1% in 1H14) as revenue grows

faster (+17.1% y/y in 1H14) than direct costs (8.2% y/y in 1H14): As at 1 July 2014, the mobile

termination rates will decline 13.9% y/y and this will result in lower interconnect costs being

paid. Additionally, airtime commissions are likely to decline in the longer term as more people

top-up via M-PESA. Safaricom incurs M-PESA commissions when subscribers deposit or with-

draw money from M-PESA. With more payment solutions available on M-PESA, we expect few-

er commissions will be paid.

EBITDA margin expansion (EBITDA margin is 41.7% in 1H14) will be driven by growth in data

revenues (mobile data and fixed data EBITDA margins are 55.0% and 43.0% respectively in

1H14): Safaricom’s EBITDA margin was 41.7% in 1H14. The improvement in margins was as a

result of 43.1% y/y growth in mobile data and a 12.0% y/y increase in voice revenue. Mobile

data has the highest EBITDA margin at 55.0% followed by voice which has an EBITDA margin of

53.0%. Fixed Data EBITDA margins are close to the group margin at 43.0%. SMS EBITDA margins

are relatively low at 28.0% due to promotions and discounts given to customers. M-PESA has

the lowest EBITDA margins at 17.0%. The low margins are as a result of fees paid to M-PESA

agents, royalties paid to Vodafone for M-PESA and the cost of maintaining the M-PESA system

in Germany. We, however, expect M-PESA margins to improve with a new faster and more effi-

cient M-PESA system being built in Kenya. Also, with more M-PESA agents and new M-PESA

products like the new merchant service, LIPA NA M-PESA, we expect fewer withdrawals and

therefore, an improvement in margins. We also note that M-PESA is a very strong customer

retention tool for voice revenue.

(Source: Safaricom, Kestrel Capital Research)

(Source: Safaricom)


Product EBITDA Margins Contribution to Revenue

Mobile Data 55.0% 6.1%

Voice 53.0% 60.6%

Fixed Data 43.0% 1.8%

SMS 28.0% 9.2%

M-PESA 17.0% 18.1%

The company will earn net finance income due to more cash than borrowings: With 98.5% of

all mobile subscribers on pre-paid contracts, the industry is very cash generative. As at the end

of 1H14, Safaricom had KES 19.8bn in cash and cash equivalents. Of this amount, it had to pay

KES 12.4bn in dividends. We expect Safaricom to generate EBITDA of KES 31.9bn in 2H14 adding

to the KES 7.4bn cash balance following the payment of the FY13 dividends. We expect addi-

tional capital expenditure of KES 16.0bn in the 2H14 leaving approximately KES 23.3bn for pay-

ment of FY14 dividends and netting off borrowings. Safaricom has KES 12.0bn in non-current

borrowings in a two tranche corporate bond. The first tranche of KES 7.5bn mature in 2H15

(November 2014) and the second tranche of KES 4.5bn will be paid in 2H16 (December 2015).

Following the maturity of the bond, we don’t expect the company to refinance the bond as it

has adequate cash generated internally to finance capital expenditure. However, it may consid-

er borrowing should an attractive acquisition target present itself.

Capital expenditure will remain stable (at approximately KES 27.0bn per annum) as invest-

ment in the network improvement continues: Safaricom estimates that it will spend approxi-

mately KES 27.0bn in capital expenditure in FY14. By virtue of being the most profitable tele-

communications company in Kenya, Safaricom has been able to invest in its network significant-

ly ahead of its competitors. It plans to continue to do so going forward. Most of the company’s

capital expenditure will be spent on improving its network. While the “Best Network in Kenya”

programme will come to an end, investment in the network is a continuous process. It will

grow, modernize and optimize its cell sites. The company is also looking to add more 2G and 3G

capacity and invest in growing its fibre cable. Also, should the government allocate Safaricom

with more spectrum and a 4G license then the company will invest significantly to put up the

infrastructure for the 4G technology. We forecast that capital expenditure intensity will decline

with the absolute figure for capital expenditure remaining stable at approximately KES 27.0bn

per annum.

Free cash flows to rise (3 year forward CAGR of 49.5%) on growing EBITDA and stable capital

expenditure: In 1H14, following the 29.4% y/y increase in EBITDA, improvement in working

capital management (KES 2.06bn) and subdued capital expenditure (KES 10.6bn), free cash flow

rose 149.9% y/y to KES 12.9bn in 1H14. We believe that this is indicative of what to expect go-

ing forward. We forecast that EBITDA will grow at a 3 year forward CAGR of 22.8% and capital

expenditure will remain stable resulting in higher free cash flows.

(Source: Safaricom, Kestrel Capital Research)


We expect higher dividends (3 year forward CAGR of 47.8%) as free cash flows continue to

grow: With free cash flows expected to grow strongly over the next couple of years, we fore-

cast higher dividends if attractive acquisition opportunities don’t present themselves. In 2012,

Safaricom was rumored to have bid for Access Kenya. However, Access Kenya was eventually

sold to Dimension Data in 2013. This acquisition would have enabled Safaricom grow its fixed

data competency. In February 2014, it was reported that Safaricom and Airtel had made a bid

for Essar Yu. Safaricom was to take up Essar Yu’s infrastructure. The acquisition of the addition-

al infrastructure will help Safaricom improve its network quality and coverage. Following the

above examples, we believe that Safaricom will take advantage of opportunities to make strate-

gic acquisitions. Provided no major acquisitions in the data space or other ancillary businesses

occur, we forecast that dividends will grow at a 3 year forward CAGR of 47.8%.


Negatives Handsets sales decline ahead of the introduction of 16.0% VAT: Handset sales declined 8.6%

y/y (-11.6% h/h) in 1H14. The decline was ahead of implementation of the new VAT law in Sep-

tember 2013. The new VAT law has resulted in a 16.0% increase in all handset prices and is like-

ly to result in a decline in the volume of handsets sold in 2H14. Last year, there was an accelera-

tion in handset sales ahead of the deadline for the switching off of counterfeit phones. Notably,

some manufacturers have reduced their prices to ensure some phones (especially low cost

smartphones) remain at the same prices as before the new VAT law.

Accelerated depreciation will drag down earning growth: By upgrading its cell sites before

their useful lives come to an end, the company will incur accelerated depreciated costs in FY14.

This will result in lower earnings. However, we believe that this will result in improvements in

the network with the benefits more than making up for the costs incurred. Also, the accelerated

depreciation will have no impact on dividends.

The share price seem high at current levels relative to regional comparables: Safaricom is now

trading at a trailing P/E of 26.7x and EV/EBITDA of 9.6x compared to the regional average com-

parable P/E of 12.2x and EV/EBITDA of 6.9x. However, the company’s growth prospects (+44.9%

y/y growth in EPS in 1H14) more than justify the premium.

We expect increased competition on M-PESA and fixed data from new players: While M-PESA

is not designed take deposits, M-PESA subscribers occasionally leave deposits in their accounts

(The maximum allowable account balance is KES 100,000). These are deposits that could have

easily been kept at banks. M-Shwari now allows subscribers to move deposits from M-PESA into

a bank account held at Commerical Bank of Africa (Safaricom’s partner). Now, Safaricom has

launched a new product, LIPA NA M-PESA, which works like a merchant service but at cheaper

price (1.0% of the value of the transaction). These two products the company will compete di-

rectly with banks and as a result, the company could see increased pressure from the banking

sector. Already, several companies have put in applications with CCK to become Mobile Virtual

Network Operators. Mobile Virtual Network Operators provide telecommunications services by

leveraging off of the resources larger Networks. Mobile Virtual Network Operators therefore

lease excess capacity on the existing licensed networks and roll out their own services. Among

the companies that have applied for this license are Tangaza Pesa, Zioncell, Equity Bank and

Nakumatt Holdings. By having their own mobile networks, they will be able to roll out their own

point of sale terminals and mobile money agencies. These will enable them to compete directly

with Safaricom’s M-PESA and LIPA NA M-PESA On the fixed data segment, Access Kenya was

acquired by Dimension Data, a South African IT services company owned by Nippon Telegraph

and Telephone, the largest telecommunications company in the world by revenue. Dimension

Data has financial strength, technical competency and IT infrastructure to directly compete with

Safaricom.


Safaricom might be a target for increased regulation due to its dominant market position: As

at the end of 1H14, Safaricom had 79.1% of industry voice minutes, 95.6% of industry SMS,

73.2% of mobile data subscribers and 90.0% of mobile money subscribers. The company is in a

strong position and is careful not to abuse this competitive advantage. However, it could be a

target for increased regulation, additional fees and taxation.


Financial Summary

KES bn 2H13 1H14 2H14F 1H15F 2H15F 1H16F 2H16F

Income Statement

Voice revenue 40.24 41.92 43.57 44.69 45.91 47.67 49.50

Messaging revenue 5.86 6.35 6.98 7.24 7.52 7.81 8.11

Mobile Data revenue 3.34 4.25 5.15 6.24 7.56 9.16 11.09

Fixed Data revenue 1.10 1.22 1.97 2.23 2.52 2.86 3.23

M-PESA revenue 11.41 12.50 15.19 16.57 18.06 19.70 21.48

Service revenue 61.95 66.24 72.86 76.98 81.58 87.19 93.41

Handset revenue 2.50 2.22 2.38 2.41 2.44 2.47 2.51

Acquisition and other 0.72 0.74 0.89 1.06 1.27 1.52 1.82

Total Revenue 65.17 69.20 76.12 80.45 85.29 91.18 97.73

Direct costs (23.86) (24.85) (27.03) (28.24) (29.60) (31.29) (33.14)

Contribution 41.31 44.35 49.09 52.20 55.69 59.90 64.59

Operating Costs (14.45) (15.50) (17.74) (18.74) (19.87) (21.25) (22.77)

EBITDA 26.86 28.85 31.36 33.46 35.81 38.65 41.82

Deprec. & arm. (12.17) (12.70) (12.75) (14.37) (14.27) (14.41) (14.31)

Net financing cost (0.78) (0.24) 0.04 0.31 1.94 2.11 4.28

Taxation (4.17) (4.65) (5.59) (5.82) (7.04) (7.91) (9.54)

Net Income 9.74 11.26 13.05 13.58 16.43 18.45 22.25

EPS 0.24 0.28 0.33 0.34 0.41 0.46 0.56

DPS 0.31 - 0.38 - 0.58 - 0.76

Balance Sheet

Equity 80.27 91.53 92.18 105.75 106.97 125.42 124.45

Borrowings 12.00 12.00 4.50 4.50 - - -

Other liabilities - - - - - - -

Net assets 92.27 103.53 96.68 110.25 106.97 125.42 124.45

Non-current assets 103.50 103.95 105.66 104.96 105.19 104.45 104.80

Current assets 25.36 34.49 39.09 47.87 50.90 68.07 69.53

Current liabilities (36.59) (34.91) (48.07) (42.58) (49.11) (47.10) (49.88)

Net assets 92.27 103.53 96.67 110.25 106.97 125.42 124.45

Cash flow statement

Net operating cash flows 25.48 18.74 29.32 28.65 31.28 33.56 37.37

Net investing cash flows (16.85) (13.15) (14.46) (13.68) (14.50) (13.68) (14.66)

Free cash flows 8.63 5.59 14.85 14.98 16.78 19.89 22.71

Net financing cash flows (7.60) (8.23) (12.40) (7.50) (15.21) (4.50) (23.22)

Change in cash 1.03 (2.64) 2.45 7.48 1.57 15.39 (0.52)

Cash at the start 13.87 15.00 12.36 14.81 22.29 23.86 39.25

Cash at the end 15.00 12.36 14.81 22.29 23.86 39.25 38.73



Financial Summary

KES bn FY10 FY11 FY12 FY13 FY14F FY15F FY16F

Income Statement

Voice revenue 64.58 63.50 68.96 77.66 85.49 90.60 97.16



Fixed Data revenue 0.08 0.84 1.37 2.11 3.19 4.75 6.09

M-PESA revenue 7.56 11.78 16.87 21.84 27.69 34.63 41.18

Service revenue 80.30 88.20 100.19 118.05 139.10 158.55 180.60

Handset revenue 3.66 6.64 5.94 4.93 5.55 6.24 7.02

Acquisition and other - - 0.87 1.31 1.47 1.66 1.87

Total Revenue 83.96 94.84 107.00 124.29 146.12 166.45 189.48

Direct costs (28.50) (37.24) (43.47) (46.26) (51.88) (57.85) (64.43)

Contribution 55.46 57.60 63.53 78.03 94.24 108.60 125.06

Operating Costs (18.85) (21.87) (26.03) (28.85) (33.24) (38.62) (44.02)

EBITDA 36.61 35.73 37.50 49.18 61.00 69.99 81.04

Deprec. & arm. (13.99) (16.33) (17.35) (22.08) (25.45) (28.64) (28.72)

Net financing costs (1.64) (1.04) (2.78) (1.65) (0.20) 2.25 6.39

Taxation (5.82) (5.20) (4.74) (7.91) (10.24) (12.86) (17.44)

Net Income 15.16 13.16 12.63 17.54 25.10 30.73 41.27

EPS 0.38 0.33 0.32 0.44 0.63 0.77 1.03

DPS 0.20 0.20 0.22 0.31 0.38 0.58 0.76

Balance Sheet

Equity 62.30 67.45 72.08 80.27 92.18 106.97 124.45

Borrowings 7.61 12.11 12.10 12.00 4.50 - -

Other liabilities 0.40 0.18 0.10 - - - -

Net assets 70.30 79.74 84.28 92.27 96.68 106.97 124.45

Non-current assets 81.55 92.15 100.71 103.50 105.66 105.19 104.80

Current assets 22.57 21.70 21.19 25.36 39.09 50.90 69.53

Current liabilities (33.82) (34.12) (37.62) (36.59) (48.07) (49.11) (49.88)

Net assets 70.30 79.74 84.28 92.27 96.67 106.97 124.45

Cash flow statement

Net operating cash flows 24.05 31.00 33.24 39.13 48.85 60.65 71.50

Net investing cash flows (18.97) (26.85) (25.68) (25.36) (27.61) (28.18) (28.34)

Free cash flows 5.07 4.15 7.55 13.77 21.24 32.48 43.16

Net financing cash flows 1.34 (9.62) (4.01) (7.58) (20.63) (22.71) (27.72)

Change in cash 6.41 (5.46) 3.55 6.19 0.61 9.76 15.44

Cash at the start 4.31 10.72 5.26 8.81 15.00 15.61 25.37

Cash at the end 10.72 5.26 8.81 15.00 15.61 25.37 40.81



Financial Ratios

FY10 FY11 FY12 FY13 FY14E FY15F FY16F

Profitability Ratios

Contribution margin 66.1 60.7 59.4 62.8 64.5 65.2 66.0

EBITDA margin 43.6 37.7 35.0 39.6 41.7 42.0 42.8

Operating margin 26.9 20.5 18.8 21.8 24.3 24.8 27.6

Pretax margin 25.0 19.4 16.2 20.5 24.2 26.2 31.0

PAT margin 18.1 13.9 11.8 14.1 17.2 18.5 21.8

Return on investment

Operating ROA 17.8 17.1 21.6 26.0 27.5 31.7

ROaA 12.1 10.7 14.0 18.3 20.4 25.0

Return on total capital 25.9 24.6 30.7 37.6 40.6 45.2

ROaE 20.3 18.1 23.0 29.1 30.9 35.7

Activity Ratios

Inventory Turnover 8.5 10.2 19.0 12.1 8.7 8.7

Receivables Turnover 9.7 10.5 13.9 11.2 8.8 8.8

Payables Turnover 1.4 1.3 1.6 1.6 1.4 1.4

Working capital turnover (8.0) (7.4) (9.0) (14.5) (46.3) 17.7

Fixed asset Turnover 1.1 1.1 1.2 1.4 1.6 1.8

Total asset Turnover 0.9 0.9 1.0 1.1 1.1 1.1

Liquidity Ratios

Current Ratio 0.7 0.6 0.6 0.7 0.8 1.0 1.4

Quick Ratio 0.6 0.5 0.5 0.6 0.7 0.9 1.2

Cash Ratio 0.3 0.2 0.2 0.4 0.3 0.5 0.8

Solvency Ratio

Net Debt/Assets 5.7 8.7 8.4 4.1 (1.9) (12.4) (22.2)

Net Debt/Capital 8.5 12.4 12.2 5.7 (2.9) (18.1) (31.1)

Net Debt/Equity 9.6 14.6 14.3 6.5 (3.1) (18.1) (31.1)

Financial Leverage 1.7 1.7 1.7 1.6 1.6 1.5 1.4

Interest coverage 13.8 18.7 7.2 16.4 177.2 (18.4) (8.2)

Net Debt/EBITDA 0.2 0.3 0.3 0.1 (0.0) (0.3) (0.5)



Valuation

EV/EBITDA Method

EBITDA 61.00

EV/EBITDA 8.00

EV 488.00

less net debt 2.81

Equity 490.81

No of shares 40.00

Price 12.27

P/E Method

EPS 0.63

P/E 20.0

Price 12.54

FCFE Method

Risk free rate 11%

Beta 1.0

Risk premium 6%

Cost of equity 17%

Exit P/FCF 16.0

FY14 FY15 FY16F Post FY16F

Free cash flows 21.2 32.5 43.2

plus Net borrowings (8.2) (7.5) (4.5)

FCFE 13.0 25.0 38.7 618.6

Time 0 1 2 2

Discounted FCFE 13.0 21.3 28.2 451.9

Total Discounted FCFE 514.5

No of shares 40.0

Price 12.86

Blended Value

EV/EBITDA Method 12.27

P/E Method 12.54

FCFE Method 12.86

Price 12.56


Peer Comparison

Name P/E EV/EBITDA Dividend Yield P/B

SAFARICOM LTD 26.7 9.6 2.6 5.8

MTN GROUP LTD 16.4 6.9 4.4 3.7

VODACOM GROUP LTD 12.8 6.9 7.1 8.1

ECONET WIRELESS ZIMBABWE LTD 7.1 3.8 - 1.8

AIRTEL NETWORKS ZAMBIA PLC 7.9 2.7 4.2 2.0

MEDIAN 12.8 6.9 4.2 3.7

AVERAGE 13.2 5.7 3.7 4.3

(Source: Bloomberg)

Safaricom Regional Average Regional Median Global Average Global Median

P/E 26.7 13.2 12.8 31.6 16.0

EV/EBITDA 9.6 5.7 6.9 10.5 7.2

Dividend Yield 2.6 3.7 4.2 2.7 2.0

P/B 5.8 4.3 3.2 6.2 2.8



FY13 Results

Safaricom released its 1H14 results recording growth in Net Profit of 44.9% y/y to KES 11.3bn.

The rise in profits was driven by strong growth in total revenue (+17.1% y/y) and improvements

in cost efficiency (EBITDA margin: +399bps to 41.7%). The growth in revenue was largely sup-

ported by non-voice revenues which grew much faster than voice revenues. (30.2% y/y com-

pared to voice revenues which were up 12.0% y/y). Below are key highlights of the results.

1H13 2H13 1H14 Actual 1H14 E % y/y ch % h/h % var

Income Statement

Voice revenue 37.42 40.24 41.92 41.56 12.0 4.2 0.9



Fixed Data revenue 1.01 1.10 1.22 1.24 20.8 10.9 (2.0)

M-PESA revenue 10.43 11.41 12.50 12.35 19.8 9.6 1.2

Service revenue 56.10 61.95 66.24 64.69 18.1 6.9 2.4

Handset revenue 2.43 2.50 2.22 2.53 (8.6) (11.2) (12.3)

Acquisition and other 0.59 0.72 0.74 0.86 25.4 2.8 (14.1)

Total Revenue 59.12 65.17 69.20 68.09 17.1 6.2 1.6

Direct costs (22.96) (23.30) (24.85) (24.65) 8.2 6.7 0.8

Contribution 36.16 41.87 44.35 43.43 22.6 5.9 2.1

Operating Costs (13.87) (14.98) (15.50) (15.86) 11.8 3.5 (2.3)

EBITDA 22.29 26.89 28.85 27.57 29.4 7.3 4.7

Depreciation & amortization (9.91) (12.17) (12.70) (13.87) 28.2 4.4 (8.4)

Net finance income/ (costs) (0.87) (0.78) (0.24) (0.57) (72.4) (69.2) (57.9)

Taxation (3.74) (4.17) (4.65) (3.94) 24.3 11.5 18.1

Net Income 7.77 9.77 11.26 9.19 44.9 15.3 22.5

EPS 0.19 0.24 0.28 0.23 44.9 15.3 22.4

Balance Sheet

Equity & Minority Interest 70.50 80.27 79.25 89.46 12.4 (1.3) (11.4)

Borrowings 12.00 12.00 12.00 12.00 -

Net assets 82.50 92.27 91.25 101.46 10.6 (1.1) (10.1)

Non-current assets 99.66 103.50 102.33 102.57 2.7 (1.1) (0.2)

Current assets 28.31 25.36 33.81 33.54 19.4 33.3 0.8

Current liabilities (45.47) (36.59) 44.89 (34.65) (198.7) (222.7) (229.6)

Net assets 82.50 92.27 91.25 101.46 10.6 (1.1) (10.1)


Cash flow statement

Net operating cash flows 13.65 25.48 24.32 17.89 78.1 (4.5) 36.0

Net investing cash flows (8.51) (16.85) (11.48) (12.94) 34.8 (31.9) (11.3)

Free cash flows 5.14 8.63 12.85 4.95 149.9 48.9 159.4

Net financing cash flows (0.08) (7.60) (8.03) (8.23) 9,579.1 5.7 (2.4)

Change in cash 5.06 1.03 4.81 (3.28) (4.9) 366.5 (246.8)

Cash at the start 8.81 13.87 15.00 15.00 70.3 8.2 (0.0)

Cash at the end 13.87 15.00 19.81 11.72 42.9 32.1 69.0

Statistics

Total Customers 19.22 19.42 20.82 19.67 8.3 7.2 5.8

M-PESA customers 15.23 17.11 18.15 17.33 19.2 6.1 4.7

Mobile Data customers 5.59 7.13 8.48 7.50 51.7 18.9 13.1

Fixed Data customers 6718 6731 6931 7431 3.2 3.0 (6.7)

Service revenue ARPU* 486 532 561 548 15.4 5.5 2.4

Voice ARPU* 324 345 355 352 9.6 2.9 0.9

SMS ARPU* 37 50 54 50 45.9 8.0 8.0

M-PESA ARPU* 114 111 115 119 0.9 3.6 (3.4)

Mobile Data ARPU* 87 78 84 80 (3.4) 7.7 5.0

Fixed Data ARPU* 26403 27237 29337 27918 11.1 7.7 5.1

Ratios

Contribution margin 61.2 64.2 64.1 63.8 2.93 (0.16) 0.30

EBITDA margin 37.7 41.3 41.7 40.5 3.99 0.43 1.20

Net profit margins 13.1 15.0 16.3 13.5 3.13 1.28 2.78

ROaE** 22.0 24.3 28.4 20.5 6.37 4.07 7.87


Key Highlights: Voice revenue grew 12.0% y/y on impressive subscriber growth (+8.3% y/y, +7.2% h/h)

and higher voice ARPUs (+9.6% y/y, +2.9% h/h): Safaricom managed grow its total sub-scribers by 8.3% y/y (+7.2% h/h) despite already having a significant share of the industry subscribers (65.1% as at 31 March 2013). During the period, Airtel Kenya (Safaricom’s clos-est competitor by subscriber numbers) raised its call rates to match Safaricom’s. The attrac-tiveness of Safaricom’s products, in particluar M-PESA, attracted more subscribers on to the network as indicated by the decline in churn from 28.5% in 1H13 to 18.4% in 1H14. The rise in voice ARPUs (+9.6% y/y, +2.9% h/h) was a factor of higher minutes of use even as the effective yield per minute declined following the 20.1% y/y cut in Mobile Termination Rates. Going forward, we expect voice ARPUs to keep growing due to higher minutes of use as call quality improves. Also, last year’s subscriber numbers in 2H13 were affected by the switching off of counterfeit phones and unregistered lines. We don’t expect the same to reoccur in 2H14.

SMS revenues increased 48.7% y/y (+8.4% y/y) driven by the Bonyeza Ushinde promo-tion: Last year, Safaricom ran the Bonyeza Ushinde promotion which contributed signifi-cantly to the 30.0% y/y growth recorded in FY13. The effects of the promotion were sticky as the higher volumes recorded during the promotion continued into the second half of 2013. In 1H14, Safaricom ran the second round of the promotion but with a higher price


per SMS. SMS ARPU rose 45.9% y/y (8.0% h/h) in 1H14. The additional effect of growing subscribers numbers as well as the popularity of the promotion amongst existing subscrib-ers resulted in much higher SMS volumes. Also, the new SMS bundle products, following the removal of the unlimited SMS bundle, continues to generate higher SMS volumes at a slightly higher average price per SMS than the unlimited SMS bundle did.

Fast growth in active mobile data customers (+51.7% y/y) drove the 43.1% y/y growth in mobile data revenues: As at end of March 2013, Safaricom was the largest mobile data provider with 74.4% of all mobile data subscriptions. Despite this, it was able to grow its active mobile data subscriptions by 51.7% y/y. A 21.0% cut in the average price per MB drove up mobile data usage by 18.0%. While there was some dilutive impact from the low-er prices, we expect usage to continue growing going forward. The company announced that it would build the largest 4G network in the region over the next 24 months which will continue to drive the growth of mobile data.

M-PESA revenues rose 19.8% y/y (9.6% h/h) on increased subscribers (19.2% y/y): The rise in M-PESA revenues (+19.6% y/y, +9.6% h/h) was largely due to increased subscribers. M-PESA subscribers grew 19.2% y/y (+6.1% y/y). The benefits the newly launched products (e.g. LIPA NA M-PESA) were yet to be felt as average usage per customer only grew 2.0% y/y. M-PESA continues to have a lot of growth potential should the benefits of the new prod-ucts begin to accrue.

EBITDA margin rises 399bps to 41.7%: Direct costs increased 8.2% y/y (+6.7% h/h ) while operating costs were up 11.8% y/y (3.5% h/h). This was much slower than the 17.1% y/y growth in total revenue. The result was an improvement in EBITDA margin to 41.7% in 1H14 from 37.7% reported in 1H13. Some of the cost improvement initiatives include in-creasing the number of airtime top-ups that are being carried out on M-PESA (34.0% of total top-ups) which lowers the amount paid to airtime dealers.

Free cash flows rose 149.9% y/y: Following the 29.4% y/y (+7.3% y/y) increase in EBITDA,

improvement in working capital management (KES 2.06bn) and subdued capital expendi-

ture (-31.9% h/h, +34.8% y/y), free cash flow rose 149.9% y/y to KES 12.9bn. The company,

however, expects capital expenditure to rise in 2H14 to KES 26.0bn to KES 27.0bn for FY14.

The company also raised its guidance for FY14F free cash flow from a range of KES 15.5bn -

KES 17.5bn announced at the start of the year to a range of KES 20.0bn – KES 21bn.


Recommendation guide

STRONG BUY: Highly undervalued/ strong fundamentals

BUY: Good value/ strong fundamentals

ACCUMULATE: Buy on price dips

HOLD: Correctly valued with little pricing upside or downside

LIGHTEN: Overvalued by the market/ Reduce exposure/Declining fundamentals/

industry concerns

SELL: Weak fundamentals and challenging operating environment/Highly

overpriced

Disclaimer Note: Readers should be aware that Kestrel Capital (EA) Ltd does and seeks to do business with companies covered in its research

reports. Consequently, a conflict of interest may arise that could affect the objectivity of this report. This document should only be

considered a single factor used by investors in making their investment decisions. The reader should independently evaluate the

investment risks and is solely responsible for their investment decisions.

The opinions and information portrayed in this report may change without prior notice to investors. This publication may not be distrib-

uted to the public media or quoted or used by the public media without prior and express written consent of Kestrel Capital (EA) Ltd.

Directors, staff of Kestrel Capital (EA) Ltd and their family members, may from time to time hold shares in the company it recommends

to either buy or sell and as such the investor should determine for themselves the applicability of this recommendation.

This document does not constitute an offer, or the solicitation of an offer, for the sale or purchase of any security. Whilst every care

has been taken in preparing this document, no representation, warranty or undertaking (express or implied) is given and no responsi-

bility or liability is accepted by Kestrel Capital or any employee of Kestrel Capital as to the accuracy of the information contained and

opinions expressed herein.

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